Many municipal issuers are traditionally required to fund a debt service reserve fund (“DSRF”) in connection with the issuance of their bonds. In most cases the DSRF for a bond issue represents 7% to 10% of the par amount of the issue and is funded from bond proceeds. The requirement for such reserves is typically defined as maximum or average annual debt service. In contrast, for certain types of issues the DSRF is funded from program equity and may range in size from 33% to 50% of the par amount of the issue. In either case, the DSRF would be used to prevent or delay a bond default in the event that the issuer were to default on its obligation (e.g., to annually provide revenues in an amount sufficient to pay its bonds).
More particularly, in the event that the funds provided by an issuer to pay debt service were insufficient on any payment date, the securities in the DSRF would be liquidated (to the extent required) and the proceeds thereof would be used to pay debt service. If the securities in the DSRF were liquidated at a loss, then funds available in the DSRF to prevent or delay a bond payment default would be less than anticipated (e.g., by creditors and/or rating agencies). Therefore, issuers typically keep their DSRF investments substantially shorter than the term of the bonds either because of legal requirements in their bond indentures or by policy. In either case, the restrictions on investment maturity are principally motivated by credit and rating agency concerns that the issuer limit the market risk it takes on its DSRF investments to assure that the DSRF is available to serve its function (i.e., preventing or delaying a payment default). In other words, since a municipal issuer would likely view the possibility of its own default as close to 0%, the issuer's main motivation for keeping the DSRF investment short would likely be the rating and credit concern.
If a DSRF were in fact liquidated to meet a debt service shortfall, the issuer would likely be required to both: (a) make up the deficiency in the DSRF caused by the withdrawal of funds; and (b) make up the amount of any market loss. The obligation of the issuer to do so would typically be secured by the identical security as the bonds themselves. It is believed that in the municipal market, the use by an issuer of its DSRF would be viewed as essentially tantamount to a bond default. Therefore, an issuer would prefer to avoid relying upon its DSRFs for payment if at all possible. It is believed that even a poorly rated issuer would not consider allowing a draw on its DSRFs.
Of note, a liquidity commitment provided with respect to senior bonds would in effect have priority over the payment of debt service on subordinate bonds because a deficiency in a senior DSRF is typically universally higher in the flow of funds than payments to subordinate bondholders.
Of further note, DSRFs are conventionally invested in taxable securities (such as treasuries or agencies). The yield that may be retained by an issuer on such taxable investments associated with a DSRF are typically restricted by regulation (e.g., by Federal arbitrage regulations) such that the yield may not exceed the yield on the related bonds. As discussed above, issuers generally invest in securities with a much shorter average life than their bonds. Under most market conditions, they can nevertheless earn the bond yield (i.e., the maximum yield that they can retain) on their initial investments. However, they take market risk that they will be able to earn the bond yield on reinvestments of the debt service reserve fund.
In summary, because DSRFs are typically bond funded, the issuer incurs costs to fund a DSRF and, as noted above, the issuer also has the possibility of incurring negative arbitrage when the DSRF investments mature. Accordingly, an increasing number of issuers elect to purchase a surety policy from a bond insurer to fund any required draws from the DSRF (rather than funding any required draws from the DSRF itself) Such a bond insurer surety policy generally costs 1.25% or more of the amount of the DSRF.
On the other hand, some issuers have invested in longer taxable investments and entered into a liquidity agreement for another entity to purchase the DSRF investments at par in the event that the DSRF is required to be liquidated (i.e., in order to make a payment on an issuer's bonds for which the issuer has not provided the required funds). Of note, such an issuer could not have retained earnings in excess of the bond yield. However, by essentially eliminating the possibility of negative arbitrage on the DSRF, the issuer would have fixed its cost of funding the debt service reserve fund at:
(a) the issuance cost relating to the DSRF (such cost would be about 0.5% of the amount of the DSRF) plus;
(b) the cost of the liquidity commitment.
Since, as mentioned above, an issuer's traditional alternative has been to pay about 1.25% of the DSRF for a surety, this approach could be cost effective if the liquidity agreement cost less than about 0.75% of the par amount of the DSRF or if the cost of a surety for a particular issuer would be higher than 1.25% of the DSRF. In contrast, if the liquidity agreement were to cost greater than about 5 basis points per annum, then the issuer might benefit only slightly (if at all) from the use of the taxable investments plus liquidity agreement versus the use of the surety.
In any case, neither such a traditional surety mechanism nor such a traditional taxable investment liquidity commitment mechanism provides for a liquidity commitment in connection with a tax-exempt investment associated with a DSRF, as provided for by the present invention.